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CBDC, Featured

Interoperability Crucial in CBDC: HashCash

Be it B2C, B2B, or P2P, the lack of interoperability among multiple payment methodologies including legacy payment systems, leads to delay, rise in user cost, infrastructure cost, and complexity and that’s why it is crucial in CBDC. 

Innovative payment models are aimed at transforming monetary systems commerce, and banking. However, interoperability is one aspect that is often neglected in the design process. In such cases, the resultant system ends up being rather inefficient. Be it B2C, B2B, or P2P lack of interoperability among multiple payment methodologies including legacy payment systems, leads to delay, rise in user cost, infrastructure cost, and complexity.  

Financial market infrastructure is more likely to lose significant netting of inflows against outflows when using a feebly interoperable system, thus, necessitating unreasonably high cash buffers.

Also Read: A Brief Guide On Central Bank Digital Currencies

Understanding  ‘Interoperability’

To get to the bottom of interoperability, we may imagine a payment system to be a collection of multi-account ledgers that record funds available to account holders. Each ledger is capable of instant transfer of funds between any two accounts on that particular ledger. Two ledgers are deemed interoperable if there exists at least one intermediary holding accounts on both the ledgers. This will ensure that a request for transfer from ledger A to ledger B is accomplished by transferring from the source account on A to the intermediary’s account on A. This is followed by the transfer of an equal amount to the intermediary’s account on B and from there onwards to the destination account on B.

For interoperability to be effective at supporting payment system efficiency, transfers should be done at negligible or nearly negligible latency and user cost. The definition of interoperability is extended by calling two different ledgers interoperable if they are elements of a network of interoperable ledgers.

A conventional two-tiered bank-based payment system, as depicted, offers a degree of interoperability. The inner tier consists of a central bank (CB) and banks b1, b2, . . . , bn holding deposit accounts at the central bank. In the inner tier, banks make most of their payments to each other by transferring deposits held in their accounts at the central bank.

The outer tier comprises the banks and their customers, c1, c2, . . . , ck, who make direct payments from their own bank accounts to accounts at other banks. The account ledgers of two different banks are thus interoperable via an inner-tier settlement system, such as Fedwire in the U.S. or the Eurozone’s Target2.

In practice, however, the degree of interoperability is reduced, often significantly, by user costs and fees of various types, significant latencies (often more than a day), and limited time-of-day access. Some payment system authorities, including those of the United Kingdom and the Eurozone, have reacted by introducing “fast payment systems” that offer almost instant transactions, around the clock, with extremely low user fees. Still, however, fast payments are not dominant in the U.K. and the Eurozone and are in a much earlier stage of development in the United States.

BDC is based on central bank deposit accounts for every user has only one ledger. With the widespread use of CBDC, interoperability should not be an issue, given the ease of arranging for low-cost instant transfers across the entire economy.

CBDC

Figure: A schematic representation of a two-tiered payment system; the inner tier consisting of a central bank and other banks. Banks make most of their payments to one another by transferring reserves held in their deposit accounts at the central bank. The outer tier of the payment system comprises banks and their customers, who can direct payments from their own bank accounts to the bank accounts of others.

Interoperability With CBDC

Most central banks have, to date, shied away from providing CBDC directly to everyone in the economy. However, there have been serious efforts to build prototypes and proposals for “hybrid” or “synthetic” CBDC. This would shift the responsibility to private-sector actors on payment services associated with one or more digital currencies backed by the central bank. Of the proposed variants of this model, two are prominent:

  1. The central bank-issued CBDC “tokens” are redistributed to a broad customer base by one or more payment service providers, along with payment apps and other infrastructure. The CBDC tokens are digital representations of paper currency, as direct claims on the central bank, but are transferred electronically. Token holdings are recorded in ledger accounts maintained by the central bank or by payment service providers. Banks or technology firms qualify as payment service providers. Interoperability requires that all actors in the economy should be able to seamlessly transfer the CBDC to each other, implying a common payment technology or strong standardization.
  2. An alternative proposed by Adrian and Mancini-Griffoli (2019) states “synthetic CBDC,” payment service providers can be permitted to back their own private-sector digital currencies 100% with deposit accounts at the central bank. Effectively each of the resulting private-sector digital currencies takes the form of narrow payment-bank deposits. In this case, interoperability demands are not limited to interoperable payment technologies but extend into the perfect fungibility of the various resulting private digital currencies. This poses additional technical challenges that deserve a lengthier discourse.

Final Remarks

High-speed and greatly interoperable payment technologies of some formats have a high probability to dominate some major economies within the next decade. These new technologies will revolve around bank-account-based payment systems, central bank digital currencies, or some hybrid or synthetic form of CBDC.

Also Read: Controlled Blockchain for Enhanced Security in CBDC: HashCash

Most developed-economy central banks that have till date continued to pitch for the efficiency of bank-account-based payment systems over the deployment of CBDCs have now become more open to discussing the potential benefits of the introduction of a CBDC. There has since been a rush in all major economies to launch their CBDC.

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